Friday, 22 January 2016

Sincerity - the subjective rationality of markets

The Vietnamese have a proverb: two women and a duck make a market.
This simple saying highlights the inter-subjective nature of markets,
there is an asset (the duck) who’s price is determined through the
discussion of two subjects.

The foundation of this paper is in the claim that financial markets
should be perceived as centres of communicative, as opposed to
strategic, action. This claim rests on recognising a distinction
between markets based on market-makers (in England, ‘jobbers’)
and those based on brokers. A broker, whether an individual or a
firm, makes their money by arranging transactions between buyers and
sellers for a fee; brokers facilitate the strategic action of those
who own property. Most commercial transactions, such as buying
groceries, are facilitated by brokers, such as retail supermarkets;
in the context of financial markets brokers mediate between
‘investors’. Brokers make a living from the commission they
charge for bringing buyers and sellers together. Most general
retailers look for a 100% commission (they charge buyers twice the
price an item is sold for), auctioneers charge sellers and buyers
commissions running 10%-20% each, estate agents charge 0.5%- 3%;
commission rates fall as the value of the asset rises. While a
broker’s commission rate is proportional to the liquidity of the
asset, the absolute commission is lowest on the most liquid assets.

Market-makers, sometimes known as ‘dealers’ in the U.S.1,
will quote bid prices, at which they will buy an asset, and offer
prices, at which they will sell an asset, without knowing if the
counter-party is seeking to buy or sell the asset (though the
quantity will affect the quoted prices). The market-maker makes a
living through the bid-ask spread: the bid price is always lower than
the offer. The bid-offer spread is highest when liquidity is low and
and market-makers profit when investors are ill-informed and prices
change frequently (Bagehot, 1971:13)2, (Millo, 2003:89),
(Carruthers
and Stinchcombe, 1999:Note
14), leaving them open to the accusation that they promote
uncertainty. The general public encounter market-makers in banking,
where banks traditionally make money by lending to and borrowing from
customers at differential rates. This final observation justifies the
focus on market-making in the context of debt markets.

Stock-jobbing had a dubious reputation as the English financial
markets emerged in the late seventeenth century. In 1719 Daniel Defoe
wrote The
Anatomy of Exchange Alley in which he described
stock-jobbing as

a trade founded in fraud, born of deceit, and nourished by trick,
cheat, wheedle, forgeries, falsehoods, and all sorts of delusions;
coining false news, this way good, this way bad; whispering imaginary
terrors, frights hopes, expectations, and then preying upon the
weakness of those whose imaginations they have wrought upon
(Poitras, 2000:290)

An observation mentioned by Defoe but more explicitly stated by
Thomas Mortimer in 1761 concerned the type of person involved in
stock-jobbing. Mortimer makes the point that there are three types of
stock-jobber: foreigners; gentry, merchants and tradesmen; and “by
far the greatest number”, people

with very little, and often, no property at all in the funds, who job
in them on credit, and transact more business in several government
securities in one hour, without having a shilling of property in any
of them, than the real proprietors of thousand transact in several
years. (Poitras, 2000:291)

These jobbers did not only trade in vanilla products such as stocks
or bonds. Murphy (2009:24-30)
estimates that around 40% of the trades between 1692 and 1695 were in
stock options that were being traded in order to manage the risks of
stock trading: ‘hedging’. Evidence of the widespread use of
options comes in Colley Cibber’s 1720 play, The
Refusal (the term for an option at the time)
describing the action in Exchange Alley

There you’ll see a duke dangling after a director; here a peer and
‘prentice haggling for an eighth; there a Jew and a parson making
up the differences; there a young woman of quality buying bears of a
Quaker; and there an old one selling refusals to a lieutenant of
grenadiers (Ackroyd, 2001:308)

The role of stock-jobbers in the U.K. markets became normalised and
an accepted part of the financial system from the late eighteenth
century until 1986 when they disappeared with the ‘Big Bang’
reforms. Attard (2000)
reports that at the end of the nineteenth century the number of
jobbers and brokers on the London Stock Exchange were approximately
equal, though the proportion of jobbers increased at times when new
markets emerged. Through the twentieth century the proportion of
jobbers declined: in 1908, at the height of the market before the
collapse of Bretton-Woods there were some 3,300 jobbers to 1,700
brokers; in 1938 there were 1,433 jobbers to 2,491 brokers; in 1961,
697 jobbers to 2,694 brokers. The majority of jobbers worked in small
partnerships of one or two members but the most of the business
passed through a few large firms, such as Akroyd & Smithers, who
‘made’ the market in British government debt.

Mackenzie
and Millo (2001:19-22)
present a similar picture of the market-makers of the Chicago
exchanges as outsiders with limited reserves while
(MacKenzie, 2008:142)
describes how the Chicago market-makers were idle in the late 1960s
and a comprehensive account of market-making culture at the Chicago
Board of Trade is given in Millo (2003:88-132).
This reveals that while a ‘designated market-maker’ is obliged to
provide bid and offer quotes to a broker the majority of
market-making activity is conducted by market-makers who risk their
own capital as ‘traders’.

On this basis we can describe a market made by market-makers as a
discursive arena. A market-maker will make an assertion as to the
price of an asset by giving the market a bid and offer price. If
other traders agree with the bid-offer, they let it pass and do
nothing. If, however, another trader feels the market-maker has
mis-priced the asset, they will act - challenging the assertion - by
executing a trade. Note that the specification of a bid-offer pair by
a market-maker is critical: offering to sell air for £1,000/kg
would not demonstrate anything, offering to buy air at £999.95/kg
would be challenged as a mis-pricing. It is through this process,
whereby one market-maker makes a claim as to what is a true price and
then the claim being challenged, that the market seeks to reach an
understanding as to the price of an asset. The process is one where
traders are continually taking yes-no positions to validity claims
implicit in quotes. Central to this process is that the
market-maker’s and dealer’s “manifest intention is meant
as it is expressed” (Habermas, 1985:99)
with the evidence being that they are prepared to act on their
utterances by having ‘skin in the game’ (Taleb
and Sandis, 2014).

In what followers we shall use the term ‘jobber’, as distinct
from ‘broker’, to refer to an agent acting as a market-market,
trader or arbitrageur3:
that is they are concerned with asset pricing as distinct from asset
valuation, which is the aim of investors. We can contrast the markets
mediated by jobbers from the type of markets mediated by brokers,
were commodity owners undertake exchange, by considering an extreme
example of commodity exchange where a central authority sets the
price, such as the Emperor Charlemagne who in the ninth century, at
the start of feudalism, set the ‘just price’ of commodities that
would apply in Bordeaux, Aachen, Salzburg or Lubeck. When Charlemagne
set the price of a good throughout his empire he was setting the rate
at which a commodity would settle a tax debt, rather than relating
the price to supply and demand. This had the effect that merchants
could not move a commodity from an area of abundance to region with a
shortage, which would lead to a certain loss since prices were fixed.
This is a central problem of economics and a focus of much economic
theory is on the allocation of resources across a society.
Neo-liberal economic theory has it that the ‘market’ will achieve
an optimal distribution while Marxists argue that the institution of
private property creates the scarcity and the consequential
power-imbalances enable the bourgeois to exploit the proletariat.

The issue of the power of the price setter could be resolved by
obliging the price setter to specify not just the price at which a
commodity is brought (or sold) but by obliging them to offer both bid
and offer prices. This is an obvious practical solution but it points
to the central issue: if an authority is only giving a price at which
he is willing to buy a commodity, but not at which he is willing to
sell it, they is being insincere, in the sense that they are being
hypocritical, about the price. By requiring authority to give both
bid and offer prices their power to act arbitrarily is curtailed.
Kaye (1998:22-25)
describes how in France in the first decade of the fourteenth
century, after a century of the society’s monetisation, the
authority of Philip IV to set economic affairs was challenged by the
broad public signalling the end of feudalism.

In a market mediated by jobbers, recorded prices represent, not an
implicit agreement in the price quoted by the market-maker but, an
explicit disagreement in the market-maker’s valuation. This is
because a speculator would only trade with a market-maker if they
believed they would profit at the price quoted and this would only be
the case if the speculator believed the market-maker had mis-priced.
The statement that market prices indicate disagreement appears
incoherent with standard economic theory that argues the market price
is the true price and is discussed in Bjerg (2014:24).
Standard economic theory focuses on exchange undertaken by owners of
commodities, in this case it is reasonable to believe that the two
parties can come to some agreement as where the equivalence between
commodities should rest. This type of exchange is dominated by
objective rationality, discussed in the Reciprocity as a Foundationof Financial Economics.

We make sense of the apparent incoherence of jobber-mediated markets
delivering prices that are disputed by noting that, unlike investors,
jobbers have no commitment to the assets they trade. A jobber gives
prices in much the same manner as a good book-maker - by setting
prices that balance supply and demand and bringing to mind
Ramsey (1931:181-183).
Believing that there is an objective value of the asset they are
trading can be detrimental. Market-makers should focus on the
relative volume of buy and sell orders and traders make a subjective
assessment as the veracity of the prices given by market-makers. This
attitude is captured in Beunza
and Stark (2012:394)
where it is recorded that terms like buy and sell suggest a
commitment to assets that traders see as a sign of
un-professionalism. It was also understood by the Scholastics, who
recognised that “the individual’s responsibility in economic
activity is effectively eliminated” if finance rests solely on
objective valuations (Kaye, 1998:98-99).
The difference between broker and jobber mediated markets is
emphasised by the difference between traditional ‘cash-and-carry’
markets, where it is possible to physically hold the asset and
valuations can be regarded as objective, and ‘price discovery’
markets associated with financialisation and where the asset is
intangible and so prices are subjective (Hirsa
and Neftci, 2013:3).

Financialisation is often presented as a recent phenomenon, alongside
neo-liberalism and globalisation (for example, Krippner (2005)),
emerging after the collapse of the Bretton-Woods system of fixed
exchange rates in 1971. However, finance - the science of money - has
eclipsed commodity exchange at a number of times in the history of
western Europe. Money appears in pre-Socratic Greece (Seaford, 2004);
comes to dominate trade in the thirteenth century
(Hadden, 1994; Kaye, 1998);
and is a significant feature of seventeenth century England and the
Netherlands. These episodes of financialisation are also associated
with the democratisation of politics and the development of ‘western
science’.

An example of seventeenth century financialisation, closely linked to
globalisation at the time, is given by Poitras (2000:274-277)
who describes the emergence of stock trading in seventeenth century
Amsterdam. During this time the trade of ‘duction’ shares was
reported in de la Vega’s Confusion
deConfusiones4
(1688). Duction shares had a nominal value of one tenth a Dutch East
India Company (VOC) share but there was no expectation that holding
ten ductions would entitle someone to a VOC share: . Duction shares
appeared because it was impossible for the general public to
participate in speculation on VOC shares, which were held exclusively
by the Dutch elite and their trading incurred significant transaction
costs. Duction trading enabled the public to challenge the VOC
owners’ assessment of the value of the firm and in 1610 the VOC
board petitioned the government to prohibit the sale of shares “in
blanco” (short-selling, signifying the public felt the VOC was
over-valued). The ban was ineffective, and had to be repeated in
1624, 1630, 1636 and 1677. de Goede (2005)
discusses the similar phenomenon of ‘bucket shops’ that appeared
in the U.S. in the 1870s and enabled the American working class to
speculate on commodity prices without having to incur the cost of
trading through CBOT.

While many argue that modern (quantitative) finance starts with
Bachelier’s thesis of 1900 (such as Bjerg (2014:19),
Appadurai (2015:2-3),
Roffe (2015:11))
we would argue that Bachelier’s work, and the subsequent,
independent, work of Bronzin (Zimmermann
and Hafner, 2007)
that is much closer to current theory than Bachelier, marks the end
of an era that had included the railway booms and the globalisation
associated with nineteenth century colonisation. Between the closure
of the exchanges at the start of the 1914-1918 War and the collapse
of Bretton-Woods a form of ‘gold-standard’ defined money as a
commodity and after 1945 exchange rates were based on the opinions of
American, British and Frech policy makers. Bretton-Woods collapsed
because the global power balance changed as the German and Japanese
economies grew faster than those of Britain and the U.S. In order to
regulate exchange rates in this new world order governments adjusted
central bank lending rates. In the 26 years between 1945 and autumn
1971, the Bank of England changed its lending rate 41 times, with 30%
of these changes occurring between 1966 and 1971. In the 26 years
after 1971, it changed them 216 times. As exchange rates fluctuated
so did commodity prices. An exemplar is the oil price whose control
passed from the Railroad Commission of Texas to OPEC and ultimately
to the Brent crude futures price, where jobbers on the International
Petroleum Exchange controlling the price muting the owners of the
rights to produce Brent crude. In 1908 and 2008 markets were
dominated by jobbers because their role in ‘price-discovery’ was
necessary in an uncertain world.

Market-makers gain from investors who are taking strategic decisions
of the C -M
-C
type but lose out to ‘informed traders’ engaged
in M -
M''
type speculation (Bagehot, 1971:13).
Brenner
and Brenner (1990:91)
argue that ‘investors’ are preoccupied with future scarcity and
so defer income. Because uncertainty exposes the investor to the risk
of loss, investors wish to minimise uncertainty at the cost of
potential profits, this is the basis of classical investment theory.
‘Gamblers’ will bet on an outcome taking odds that have been
agreed on by society, in a discursive manner as in sporting bets, or
based on stable statistics, as in roulette. ‘Speculators’ bet on
a mis-calculation of the odds quoted by society and the reason why
speculators are regarded as socially questionable is that they have
opinions that are explicitly at odds with the consensus (Beunza
and Stark, 2012:394).

Gambling is today regarded as profane, but this was not always the
case. For the Greeks, the brothers Zeus, Poseidon and Hades cast lots
to divide up the universe. The Hindus believe the world was a game of
dice played between Shiva and his wife and at the heart of the epic
tale Mahabharata
is an, unfair, dice game between the Kauravas and
the Pandavas ((Sahlins, 2003:27),
(Brenner
and Brenner, 1990:1-5)).
Divination by casting lots played an important role in Judaism and
the Bible refers to the ‘judgement’ of Urim
and Thurim,
which were probably two dice (Exodus 28:30, Leviticus 27:20-21,
Samuel I 14:41). Gambling was often associated with sacrificial
practises that were widespread and are generally known by their
Native American name, potlach
((Keynes, 1936:17-19),
(Graeber, 2011:56)).

The role gambling plays in archaic societies has been studied by
Altman (1985)
and Mitchell (1988).
Altman studied an Australian aboriginal group that had access to
social security payments and there was often a surplus left over
after essentials had been bought. However, some individuals were
excluded from social security payments by the government and there
was an “inter-household variability in access to cash”. The
community regarded this variability as a subjective discrimination by
the Australian government and gambling “acted effectively to both
redistribute cash †[and] provided a means for people with no access
income to gain cash” (Altman, 1985:60-61).
This was important in non-hierarchical communities because it meant
that one arbitrary bestowal of money was not corrected by another
subjective distribution, such as redistribution by a chief. Mitchell
considered the role that gambling plays in disrupting hierarchical
social structures, such as the Indian caste system, by studying the
Wape, a Sepik community in New Guinea, and concluded that their
non-hierarchical society was maintained through gambling. The
pervasive nature of gambling in archaic communities can be explained
as it is an objective, ‘fair’, mechanism for the redistribution
of wealth (Sahlins, 2003:27).
What needs to be recognised is that this process remains valid only
so long as no single entity accumulates enough wealth that it can
bankrupt all the others.

Gambling had been outlawed in the medieval period, usually because
time spent gambling could be better used (Brenner
and Brenner, 1990:58).
However, building on Roman practice, lotteries began to be used as
means of raising public-finance in the later Medieval period. The
first private lottery appeared in the sixteenth century in Italy and
the mechanism spread to France and England (Brenner
et al., 2008:133-138)
culminating in ‘The Million Adventure’ lottery set up by the
English government and drawn in November 1694 (Murphy, 2009:34).
In the seventeenth century, William Petty, observed that lotteries
were “a tax upon unfortunate, self-conceited fools” and from the
start of the eighteenth century gambling became increasingly
associated with “the waste of time and money; the neglect of
familial and business duties; the erosion of social trust; and the
severed link between hard work, talent and gain.”
(Daston, 1998:161).

Brenner
et al. (2008:98-104)
argue that the de-legitimisation of lotteries, and gambling in
general, comes about because during the seventeenth and eighteenth
centuries there was significant social and economic change. In this
environment gambling and speculation provided the ‘lower classes’
with a means to climb up the social ladder . While the lotteries
enabled this disruptive social mobility, they were a necessary tool
of public finance that prevented the stagnation and crises suffered
by states reliant on taxation (Nash, 2000).
By the start of the nineteenth century, finance had developed to such
an extent that governments could tax more effectively, notably the
incomes of the middle classes, or to borrow from the middle and upper
classes. In 1808 the British Parliament set up a committee to
“inquire how the evils attending Lotteries have been remedied by
the laws passed”. The parliamentarians concluded that, despite the
fact that the British government was still raising money through
lotteries, “the foundation of the lottery system ...under no
...regulations ...will it be possible ...[to] divest it of ...evils”
(Brenner
and Brenner, 1990:12).
The status of lotteries was changing and in 1823 they were outlawed,
with the last draw taking place in 1826, the working classes were
excluded from the opportunities to get rich that participating in
public-finance, by purchasing lottery tickets, provided. .

Daston (1998:172-174)
argues that usury prohibitions inhibited the use of mathematics in insurance and for much of the
seventeenth and eighteenth century life-insurance provided people
with the opportunity to gamble on the lives of others. The first
life-insurance fund to be managed on the basis of mathematics was the
Scottish Ministers’ Widows Fund established in 1744 (Hare
and Scott, 1992).
The model was copied in the Presbyterian’s Ministers Fund of
Philadelphia in 1761 and the following year the English Equitable
Company was founded. Mathematics and life-tables would enable the
emerging middle-classes to provide, responsibly and prudently, for
their families in the event of their death. By the end of the century
‘gambling’, in the form of insurance, had become a legitimate
practice if based on rational foundations
(Zelizer, 1979; Daston, 1987)
and in 1774 the Life Assurance Act distinguished between legitimate
insurance and illicit gambling and became known colloquially as the
Gambling Act.

The prohibitions on gambling had an important impact on the
development of finance. In 1851, following a dispute between two
counterparties in a forward contract, English law established that
there needed to be ‘intent to deliver’ for a derivative to avoid
being classed as an illegitimate gamble (Swan, 1999:211-213);
the only legitimate exchange was of the C
-
M
-
C
type, M -
M''
of the duction trade and ‘bucketshops’ was illegitimate. While
English courts generally avoided becoming involved in the derivative
markets, U.S. courts were much more active in restricting speculative
behaviour and were vigorous in prosecuting “idlers who made profit
even while they slept” (de Goede, 2005:62,
quoting Fabian) by speculating in bucketshops rather than the
“competent men” of CBOT engaged in “the self-adjustment of
society to the probable”, as the U.S. Supreme Court ruled in 1908
(de Goede, 2005:71).
We stress how the Supreme Court ruled that only an elite could
speculate on the markets just as they prevented the poor from betting
on horse-racing by only allowing on-course betting relate these
observations to Levy (2012)’s
account of the alienation of the public from financial risk by U.S.
corporations at the end of the nineteenth century.

The strict prohibitions persisted into the late twentieth century and
in 1968 CBOT consulted lawyers about offering an index future, but
had been told it would probably be ruled as illegal. While
commodities, including stocks and bonds, could be delivered, the
‘index’ could not (MacKenzie, 2008:145).
The publication of the Black-Scholes equation, where all the
variables were ‘known’, removed uncertainty in pricing options
and meant derivatives trading was not gambling, it was, like
insurance, ‘scientific’. In similar circumstances, in 1997 the
International Swaps and Derivatives Association (ISDA) sought the
advice of an English barrister as to the regulatory status of Credit
Default Swaps (CDS): the ‘Potts Opinion’. The issue was two fold:
on the one hand iff CDS were insurance contracts they would be
regulated by strict insurance law while if they were wagers, they
would be subject to gambling legislation. A CDS is a contract where
by a protection buyer pays a regular premium to a protection seller
over a fixed period. If the contract underlying the CDS defaults (a
strictly defined term that goes beyond fails to pay) then the
protection seller pays a specific amount and the contract ceases.
Potts argued that, since the amount the protection buyer receives is
independent of the loss they incur and the related feature that
protection buyers do not need to have an interest in the underlying,
the CDS is not an insurance contract. The CDS is not a ‘wager’
since the protection buyer and seller do not hold opposite views of
whether the underlying will default or not: there is no winner or
loser.

The Bible suggests that humans suffer because they were expelled from
the Garden of Eden into a world of scarcity. The thirteenth century
rabbi, ben Maimon (Maimonides), argued that God’s punishment was
not so much about scarcity but uncertainty. In the Garden of Eden
humans had perfect knowledge, which was lost with the Fall and it is
the loss of this knowledge which is at the root of suffering: if we
know what will happen we can manage scarcity (Perlman, 1997).
Classical economics seems to hold an implicit assumption that the
price of a commodity can be known. Sometimes in economics uncertainty
comes to dominate and during these periods the central problem facing
markets is how to price an asset whose prospects are radically
uncertain. Keynes (1921:321-322)
recognised this when he observed that the largest class of problems
in economics were not reducible to the conventional concept of
probability: the problem is one of ontology, numerical probability
economic events in the future does not exist. Ramsey (1931:181-183)
criticised Keynes’ rejection of mathematical probability by
introducing the ‘Dutch Book’ argument (Hájek, 2008)
that argues probabilities (which are proxies for prices) can be
ascertained in a market-mechanism: Ramsey argues for a subjective
view of probability and that “Having any definite degree of belief
implies a certain measure of consistency”, or sincerity.

We offer the conjecture that at times of economic uncertainty, such
as when new markets are being established through either
globalisation or technology, jobbers become essential in discovering
prices through a discursive process that rests on sincerity. At such
times we cannot rely on enlightened authority to value assets and
must involve speculative traders in setting prices: it is a co-operative process as defined by Gide (1898).
This conjecture seems to be aligned to Sotiropoulos
et al. (2013)
where it is argued that profits made in the presence of uncertainty
need not be exploitative.

The pragmatic maxim demands we consider the practical consequences of
our assertions. To this end we consider the claim that sincerity is
fundamental to successful markets by examining the practice of ‘order
stuffing’ on electronic exchanges, the status of Credit Default
Swaps (CDS) and the role of Collateralised Debt Obligations (CDO) in
the Credit Crisis of 2007-2088.

The two women in the Vietnamese proverb do not require the mediation
of a broker but in this situation we can presume, because the owner
of the duck is not specified, that the price is a sincere price at
which the women would both buy and sell the duck. Modern markets,
whether financial or consumer, where technology facilitates the
matching of buyers and sellers for a relatively small fee, appear to
follow this model. However in the domain of High Frequency Trading
the practice of ‘order stuffing’, issuing large numbers of orders
to an exchange and then cancelling them within a tenth, often a
hundredth, of a second is widely regarded as being an attempt to
manipulate the market. While acknowledging this concern, the UK
Government Office for Science has not advised that any legislation
should be enacted in order to prevent the practice. They argue that
there is a competitive market in exchanges, and legislation would
discourage trading on the UK exchanges (Foresight, 2012,
Section 8.2). This fails to appreciate lessons of the LIBOR
manipulation scandal, that sincerity is foundational to the markets,
and submitting and then cancelling orders signifies a lack of
sincerity.

The Potts Opinion is not in the public domain and so we cannot be
certain of its full purpose but what is apparent is that his argument
seeks to legitimise the pricing of credit risk through jobbers rather
than brokers, whether ratings agencies or brokers. This means that
‘informed traders’ are able engage in discourse about the
liklihood of credit defaults in the future, rather than limit the
discussion to investors with vested interests. Some claim that
because CDS are so like insurance contracts they should be treated as
insurance contracts, in particular that not requiring a CDS
protection buyer to have an economic interest in the underlying
creates moral hazard. Kimball-Stanley (2009:253-261)
gives a number of reasons for re-classifying CDS but none of them is
convincing5
and all overlook the negative impact insurance companies, such as
AIG, and ratings agencies had in the Credit Crisis of 2007-2009.

With regard to the Credit Crisis in general, MacKenzie (2011:1811)
makes the point that the financial instruments at the heart of the
crisis were not priced using the jobber mediated “canonical-mechanism
market”. Valuations were based on ratings provided by agencies paid
by the producer of the financial instruments (a broker mediated
model) and mathematical models using parameters based on unrelated
markets. Because these parameters meant the models pointed to
arbitrage profits, they were widely used with only a few exceptions
(Tett, 2009:148-151).
This example leads us to distinguish to cases of financialisation.
There is the one discussed in the previous section where by jobbers
price in the abstract and apply subjective judgement. There is a
second where ‘quants’ abstract and employ algorithms and data,
what might be described as objective judgement, in a strategic
manner. The second form of abstraction failed, as most experienced
traders believed it would (Tett, 2009; Triana, 2009; Haug
and Taleb, 2011; Duhon, 2012).
From a mathematical point of view the failure of the models was in
their instrumental use; the legitimate use of mathematical models is
to develop a clearer understanding of what can be inferred about
market sentiment from jobber-mediated market prices so that trading
decisions can be taken ((Johnson, 2011);
(Beunza
and Stark, 2012:384-385);
(Duhon, 2012:265-277)).

We can conclude that some form of jobber-mediated market mechanism,
based on sincere discourse about prices in an uncertain environment,
is essential for markets to perform as they are expected to. The
Committee
on the Global Financial System (2014)
of the Bank for International Settlements has observed a decline in
market-making activity that is regarded as problematic. They argue
that regulation has reduced the ability of jobbers to provide
liquidity - by taking on risk - and this liquidity gap will have
broader economic consequences. This raises a question: why does
economic theory advocate market liquidity?

Liquidity represents the ease with which an asset can be traded. The
economic justification is that it enables investors to trade as and
when they wish, it gives them a sense of control, market risk has
been tamed (Bernstein, 1998)
by the investors ability to dynamically hedge, which rests on the
market being liquid. Furthermore, the investor wants to,
simultaneously, be able to exchange, implying a shift in supply and
demand, without changing the price. Illiquid financial markets
involve wider bid-ask spreads, or higher absolute commissions,
representing higher transaction costs and less certainty that the
market price is an accurate reflection of the asset’s value.
Liquidity is an essential assumption of the Efficient Markets
Hypothesis (Fama, 1970)
where it is taken that the “primary role of the capital market is
allocation of ownership” and so prices must “provide accurate
signals for resource allocation”.

The instrumental, as distinct from the epistemic, use of mathematics
in finance to hedge and earn arbitrage profits relies on markets
being liquid. Canonical failures in recent finance, such as
Metallgesellschaft AG in 1993, the hedge fund Long Term Capital
Management (LTCM) in 1997 (MacKenzie, 2008:233-239)
and during the Credit Crisis (Brunnermeier, 2009)
all relate to financial strategies that failed because liquidity
disappeared. This is not a modern phenomenon, in 1706 Defoe explained
the liquidity problem in the debt markets in this description of
‘Lady Credit’

Money has a younger sister, a very useful and officious Servant in
Trade ... Her name in our Language is call’d CREDIT ...

This is a coy Lass ...a most necessary, useful, industrious creature:
...a World of Good People lose her Favour, before they well know her
Name; others are courting her all their days to no purpose and can
never come into her books.

If once she is disoblig’d, she’s the most difficult to be Friends
again with us (de Goede, 2005:28)

The economic role of liquidity can be summarised as in facilitating
the strategic action of investors. Before the Enlightenment liquidity
risk, and related market risk, seem to have been an accepted feature of finance. The ‘instrumental mindsets’ that
came to dominate in the nineteenth century. However, the tools that
control market risk rely on liquidity, and, in the aftermath of the
Credit Crisis, we see an emphasis in the financial and economic on
focusing on ‘liquidity risk’. Under the current regulatory
framework liquidity providers are likely to be highly capitalised
institutions, global investment banks or hedge-funds employing
algorithms, seeking to make a profit. Based on the analysis presented
here, noting Attard (2000)’s
observation that most English jobbing firms were small partnerships
risking their personal capital, this approach has two drawbacks.
Firstly, these institutions will not be that heterogeneous and so
susceptible to ‘group think’/‘herding’/‘the superportfolio
effect’: there would not be the pluralism necessary for the
discourse required in price-discovery. Secondly, these institutions
have power and so could come to dictate prices: ‘order stuffing’
is a manifestation of this.

In light of this observation we can state the main result of this
section as a question: should society see the principle role of
markets as either; facilitating the strategic action of investors;
or, delivering prices of assets. We note that a market can always
deliver prices, with the bid-ask spread acting as a confidence
interval, but it frequently fails to deliver liquidity.

These comments suggest regulatory policy should create a clear
distinction between firms undertaking brokerage and those involved in
‘jobbing’, making it explicit which institutions are
‘speculating’ and which are ‘investing’. This implies support
of the ‘Volker rule’ in the U.S. and reversing some of the
regulatory changes associated with the U.K.’s ‘Big Bang’
reforms of 1986. This would address one of the issues that
Kimball-Stanley (2009:257-258)
identify: the fact that while one part of Goldman-Sachs was
manufacturing Mortgage Backed Securities (MBS) and selling them to
customers, another part was using the CDS market to speculate on the
value of the MBS falling. The speculators were right and were able to
signal their beliefs by trading in CDS, yet rather than criticise the
process of manufacturing MBS Kimball-Stanley (2009)
seeks to silence speculators by banning CDS. What Goldman-Sachs was
doing was mis-selling6
MBS to customers because, as an institution, it did not believe the
products had the value they were marketing them at: it was being
in-sincere.

Krippner, G. R. (2005). The financialization
of the american economy. Socio-EconomicReview,
3(2):173-208.

Levy, J. (2012). Freaks
of Fortune: The Emerging World of Capitalism and Risk inAmerica.
Harvard University Press.

MacKenzie, D. (2008). An
Engine, Not a Camera: How Financial Models Shape Markets.
The MIT Press.

MacKenzie, D. (2011). The credit crisis as a
problem in the sociology of knowledge. American
Journal of Sociology, 116(6):1778-1841.

Mackenzie, D. and Millo, Y. (2001). Negotiating a
market, performing theory: The historical sociology of a financial
derivatives exchange. In Conference
of the European Association for Evolutionary Political Economy.
http://dx.doi.org/10.2139/ssrn.279029.

1The
New York Stock Exchange employs the ‘specialist’ system that
combines the role of broker and dealer.From
our perspective this is a degradation of the market-maker’s
particular role for the benefit of the monopolisticspecialists.

3Arbitrageurs
aim to ensure prices of many assets in the market are consistent, a
practice described byFibonacci
eight hundred years ago (Fibonacci
and Sigler, 2003:180).

4While
‘confusion’ has long meant disordered, in metallurgy, a branch of
finance in the seventeenth century, itwas
used to refer to the point at which metals, such as gold and silver,
mix as molten liquids - ‘com-fundere’ = ‘withpouring’.
Confusion
de Confusiones may
be a pun implying a disordered mixing.

5In
A, the hedge-funds had an insurable interest; B, ratings agencies had
a bigger influence on pricingmortgage
default than CDS; C, banks win and lose with CDS - that’s the point
of market-making; D, disassociatingpayout
from loss does create moral hazard if there is an insured interest,
standardising payout enables pricediscovery.

6In
January 2016 Goldman-Sachs reached a $5.1bn
settlement with the US government and other agencies formis-selling
mortgage-backed securities in the run-up to the financial crisis

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About Me

I am a Lecturer in Financial Mathematics at Heriot-Watt University in Edinburgh. Heriot-Watt was the first UK university to offer degrees in Actuarial Science and Financial Mathematics and is a leading UK research centre in the fields.

Between 2006-2011 I was the UK Research Council's Academic Fellow in Financial Mathematics and was involved in informing policy makers of mathematical aspects of the Credit Crisis.